Energy Sector Continues to Pressure Corporate Bond Credit Spreads
Fixed-income returns in 2014 primarily driven by declining interest rates.
Since the beginning of the year, the average spread of the Morningstar Corporate Index has widened 3 basis points to +143. The widening was predominantly driven by the energy sector, which has widened 14 basis points thus far this year. Oil prices have continued to decline, but the rate of decline has slowed dramatically and appears to be finding support in the upper $40s. Similarly, the average spread of the Bank of America Merrill Lynch High Yield Master II Index has widened 16 basis points to +477. Within the high-yield index, the energy sector had widened +27 basis points to +783. Investors have remained cautious and continued to redeem funds from high-yield open-end mutual funds and exchange-traded funds. Last week was the eighth consecutive week of outflows and resulted in net redemptions of $8 billion over the past two months.
The new issue market was surprisingly quiet. Among the issuers for which we provide credit ratings, CBS (CBS) (rating: BBB, narrow moat) was one of the few that priced new bonds. CBS sold $1.2 billion of debt, consisting of $600 million each of 10-year and 30-year bonds priced at +165 and +215 basis points over Treasuries, respectively. These levels were slightly more expensive than our fair value estimates of +170 and +220. Last November, we highlighted that the company had $2.0 billion of debt capacity in its rating to fund additional share repurchases and it was on our Potential New Issue Supply list. CBS had raised its leverage target to 2.5 times earlier in 2014 and leverage stood at 2.1 times at the end of its third quarter. CBS could not repurchase shares during much of the third quarter as it was completing the spin-off of its outdoor business, but we expect repurchases to accelerate.
Fixed-Income Returns in 2014 Primarily Driven by Declining Interest Rates
In 2014, fixed-income returns were predominantly driven by the flattening yield curve as short-term interest rates rose and long-term interest rates declined. The increase in short-term rates was prompted by investors pricing in a higher probability that the Federal Reserve will begin to increase the federal funds rate by mid-2015. On the longer end of the curve, mixed economic indicators in the United States, weak economic conditions in Europe, and slowing growth in China prompted investors to seek the safety of U.S. Treasuries, driving long-term interest rates lower. Over the course of the year, the yield on the 2-year Treasury rose 28 basis points to 0.66%, whereas the yield of the 10-year Treasury declined 86 bps to 2.17% and the 30-year bond dropped 121 bps to 2.75%.
Overall, the Morningstar Core Bond Index rose 1.89% in the fourth quarter and 6.07% in 2014. The return was predominantly driven by the long end of the curve. In the fourth quarter, our Long Term Core Bond Index rose 4.64% and for 2014 generated a 15.10% return. These increases substantially outpaced the gains in the Short Term and Intermediate Term Core Bond indexes. Morningstar's Short Term Core Bond Index rose just 0.27% in the fourth quarter and only 1.04% in 2014. The Intermediate Term Core Bond Index rose 1.66% in the fourth quarter and 5.56% in 2014.
Because of its longer duration, in 2014 the Morningstar Corporate Bond Index outperformed both the Core Index as well as our U.S. Treasury Bond Index, even though credit spreads widened. Our Corporate Bond Index rose 1.53% in the fourth quarter and returned 7.20% for 2014, whereas Morningstar's US Treasury Bond Index returned 1.93% for the fourth quarter, but only 5.08% in 2014. Rapidly declining oil prices drove corporate credit spreads significantly wider and pushed the average credit spread of our corporate bond index 20 bps wider in the fourth quarter to end the year at +140, its highest level of the year. With its intermediate duration, the Morningstar Mortgage Bond Index also performed well as it rose 1.89% in the fourth quarter and 6.36% for the year. Between the strong dollar, continued economic growth in the U.S., and the end of quantitative easing, inflation expectations continued to drop last quarter. The Morningstar TIPS Index felt the brunt of this deterioration and rose only 0.17% last quarter and gained just 3.95% for the year.
While the Fed wound down its asset-purchase program, the European Central Bank and Bank of Japan continued their easy-money policies. This led to dollar strengthening, which in turn led to losses in those indexes denominated in U.S. dollars but invested in foreign-denominated securities. For example, the Morningstar Global Government Bond Index declined 1.37%; excluding U.S. government bonds, the Morningstar Global Ex-US Government Bond Index fell 2.72%. The Morningstar Emerging Market Composite Bond Index dropped 1.45% based on the combined 0.26% decline in the Emerging Market Sovereign Bond Index and 2.29% decline in the Emerging Market Corporate Bond Index.
Whereas last quarter we thought credit spreads were generally fairly valued, albeit at the tight end of the range that we consider fair value, we now see credit spreads at the wide end of the range that we think is fair value. We expect high-yield bonds will provide a better return than investment grade in 2015. The issuers most affected by falling oil prices have taken the brunt of losses over the past month, and the additional carry in the index will help to offset any further widening if oil prices fall further. In addition, we continue to forecast moderate economic growth in the U.S., which should hold down default rates.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.